Be Wary Of The Small And Mid Cap Rally

You may include small- and mid-caps in your portfolio for diversification, but understand that they may not replicate last year’s returns and are relatively more volatile

Returns from small-cap and mid-cap (SMID) stocks, and funds based on them, have been superlative for a while. That is good for existing investors. However, this also calls for a reality check on expectations going forward. There is an expectation building up among a section of investors that the returns delivered over the last year will be repeated next year, too. But that is where one needs to check facts.

Market Cap And AUM

As of the end of February 2024, the assets under management (AUM) of large-cap mutual funds was Rs 3.06 lakh crore. As on that date, the AUM of mid-cap funds was Rs 2.96 lakh crore, while that for small-cap funds was Rs 2.49 lakh crore. Hence, the combined AUM of SMID was Rs 5.45 lakh crore, about 1.78 times than that of large-cap funds. A year ago, at the end of February 2023, it was Rs 3.14 lakh crore for SMID funds and Rs 2.35 lakh crore for large-cap funds, which is about 1.34 times. This shows that there has been a run-up in the AUM of SMID funds.

Now, let us look at market capitalisation. Data on market capitalisation from the Association of Mutual Funds in India (Amfi) shows us that in the six months ended December 2023, the total market cap of large-cap stocks was Rs 207 lakh crore, while that of mid-cap and small-caps was Rs 57 lakh crore each. The combined market cap of SMID at Rs 114 lakh crore is 55 per cent of the large-cap market cap of Rs 207 lakh crore. To put it simply, in mutual funds, the AUM of SMID is almost double (1.78 times to be precise), but the market cap of SMID is half (55 per cent to be precise) of large-cap stocks. This indicates there is a skew in mutual funds, in terms of investor preference for SMID over one year.

Even the number of folios point towards this skewed pattern. A year ago, in February 2023, the number of folios in large-cap was 1.3 crore, while in mid-cap and small-cap, it was 1.05 crore and 1.07 crore, respectively. Hence, the combined number of folios in SMID was 1.63 times that of large-cap. Now, in February 2024, it is 1.35 crore in large-cap, 1.37 crore in mid-cap and 1.87 crore in small-cap. The combined number of folios in SMID is now 2.4 times that of large-cap. The run-up from 1.6 times to 2.4 times shows the pull factor of small-cap in the last one year.

More investors coming into the fold is a positive development, for their long-term wealth creation and from the MF industry perspective as well. However, return expectations have to be realistic.

Valuation

For valuation, let us look at the price-earnings (P-E) and price-to-book-value (P-B) multiples. These are popular valuation metrics. As of end of March 2024, the P-E ratio of Nifty 100 stocks (trailing basis), is 23.18 and P-B ratio is 4.01. On the same date, the P-E ratio of mid-cap 150 stocks (trailing basis), is 33.63 and P-B is 4.59, according to NSE data. For Nifty small-cap 250 stocks, the P-E and P-B ratios are 26.6 and 3.7, respectively. Let us look at one more category: Nifty micro-cap 250, which includes the top 250 companies beyond the Nifty 500 index constituents. The P-E and P-B ratios are 28.37 and 2.86, respectively.

There is a stretch on valuations, at least going by the trailing P-E ratios. In large-cap, it is 23.18, while in mid-cap it is 33.63. In small-caps and micro-caps, it is 26.6 and 28.37, respectively. The limited market cap of SMID, 55 per cent of large-cap stocks, is being chased by a larger pool of money, 1.78 times. There are other investors in the market besides mutual funds, but mutual funds are a major participant and the run-up is a broad-based one.

Performance Volatility

Returns over the last one year have been in the reverse order of market capitalisation (see Performance). Micro-cap 250 has given 86 per cent, small-cap 250, 64 per cent, and mid-cap 150 has 57.5 per cent, whereas the top 100 large-cap stocks have given 34.8 per cent. There is a skew in performance, but that happens in the markets. We see a similar pattern in terms of 5-year performance, too. We see a year of superlative performance.

Now, let us look at a year of muted performance. The 1-year performance till March 23, 2020, when the market went through pre-Covid correction, was in the negative. History shows that volatility of small-cap stocks and funds tend to be higher than that of large-cap ones. This is something investors have to bear in mind.

The Stress Test Cushion

As per the regulatory mandate, mutual funds have to declare every month about how many days it would take them to liquidate 25 per cent of their portfolio and 50 per cent of their portfolio. Data on historical traded volume of the stocks in the portfolio are available, and mutual funds are calculating and publishing the data based on that. The purpose is to know, if there is heavy redemption pressure, how much time it would take them to sell stocks and generate cash. A point to be noted is that this is not a new revelation per se. Mutual funds have been tracking it internally; and now it is available in the public domain.

You need not take action based only on this data point. The fund that would take lesser time to liquidate is arguably better. However, the fund that would take a longer time is not necessarily that bad. The rationale is that your investment horizon is not two days, two weeks, or two months—that is the data thrown by various funds to liquidate 25 per cent or 50 per cent of their SMID portfolio. Ideally, your horizon is not even two years, but longer, say 10 years. In that case, you need not react to whether your fund would take two days or two weeks to liquidate 25 per cent of the portfolio.

Conclusion

The great India growth story remains intact and there is a case for diversification to mid-cap and small-cap stocks in your portfolio.

However, investors should bear in mind a few things:

• Returns from SMID over last year is unlikely to be repeated next year.
• Allocation should be driven by logic, not by market frenzy.
• Volatility is part of the game, and at stretched valuations, the probability of volatility is higher.

By Joydeep Sen, Corporate Trainer and Author